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Equity Perspectives

The initial public offering (IPO) market is experiencing a strong rebound so far in 2017.  Could that be a harbinger of new sources of growth for years to come?

 

In Brief:

  • After languishing over the past three years during a period of underperformance by high-growth companies, IPOs are off to a strong start in 2017, and are expected to increase throughout in the year.
  • While the most successful IPOs to date have come from the technology sector, there also were notable debuts in the industrial and consumer sectors.
  • In evaluating an IPO’s prospects, Lord Abbett always conducts in-depth meetings with company management.
  • Any investment decision draws on input from Lord Abbett’s equities and fixed-income portfolio managers and research analysts.
 

When it comes to generating alpha, few things capture the imagination of an investor like a hot IPO that capitalizes on transformative innovation, has solid management, and has strong fundamentals. “All of the great growth companies debut through this window,” said Tom O’Halloran, Lord Abbett Partner & Director of Growth Investing. “And now that the IPO market is picking up after a couple of dormant years, we want to make sure we have a look at all of those that hold the potential to achieve that status.”

According to a recent report by EY (formerly Ernst & Young), global IPO markets in the first quarter of 2017 saw the highest number of IPOs since 2007, and were led by companies on China’s Shanghai and and Shenzen exchanges. The U.S. IPO market also was strong, fueled by a backlog of IPO candidates looking to take advantage of attractive valuations in the equity markets, and should attract more innovative companies seeking capital in the public markets for the remainder of the year.1 (See Chart 1.) Between January 1, 2017, and June 6, 2017, 63 U.S. IPOs were raising $17 billion, according to Paul Bard, Director of Research at Renaissance Capital, who believes 2017 is on track for more than 150 IPOs and $35-40 billion in proceeds—a huge increase over 2016 as shown in Chart 2.

Of course, IPOs are a scarce commodity, which can lead to mis-evaluation and excessive volatility. In fact, many of the IPOs between 2014 and 2016 either disappointed (especially those in biotech, a sector that endured a bear market), or traded sideways. As a result, IPO sponsors, particularly in the venture capital community, have waited longer to take their companies public; and with equity markets reaching new highs of late, investors are paying up for quality. 

While the most successful IPOs year to date have been sourced by the technology sector, O’Halloran said the industrial and consumer sectors also have been providing good opportunities.

“We invest in an IPO when we believe the company has healthy fundamentals, and is poised for a period of strong growth,” O’Halloran said. “We have held a number of IPOs for several years, in some cases, and have sold out and gone back into a particular holding as the stock went through the normal cycles of underperformance and outperformance.”  

Elaborating on IPO expectations, O’Halloran said, “We want the growth that we perceive in the near, intermediate and long terms to be sufficient to allow the stock to outperform a strategy’s given benchmark. We have to understand what market expectations are and to make sure they are not too high. We have to value the stock properly.”

 

Chart 1. U.S. IPO Activity Has Surged in the Last Year
U.S. IPO activity, quarterly, first quarter 2015–first quarter 2017   

Source: renaissancecapital.com.

 

Chart 2. How U.S. IPOs Have Fared Since the Technology Boom 20 Years Ago
U.S. IPO activity, 1997-2016  

Source: renaissancecapital.com.
Note: Includes IPOs with a market cap of at least $50 million and excludes closed-end funds and SPACs. Data through 12/30/16.

 

Consider the Source
When evaluating an IPO’s prospects, we consider the entity that is sponsoring the new issue. “There is a world of difference between IPO sponsors,” O’Halloran said. “A Bain Capital, Blackstone, or a Carlyle Group [all major buyout firms with established track records] are much better as sponsors than a second-, third-, or fourth-tier LBO [leveraged buyout] or private equity shop.” O’Halloran’s team generally has an even higher degree of comfort with IPOs coming from well-established venture capital firms such as Sequoia Capital or Benchmark Capital, companies that founded Cisco, Google, and eBay, for example.   

The logic goes like this: While private equity and LBO shops may enhance the value of businesses they have taken private, much of their expertise is in financial engineering. They tend to buy mature businesses and then reposition them. Major venture capital firms, on the other hand, have had, historically, more experience and knowledge in building big winners from the ground up. “Venture capital firms have greater expertise in hatching young companies that can grow to be giants,” O’Halloran said.  

Whatever the sponsor, O’Halloran’s team typically previews a prospective IPO’s Internet road show before they agree to a one-on-one meeting with management or to a pre-marketing luncheon. The Internet road show enables O’Halloran and members of the team to fine-tune the issues and associated questions. This enhances the quality of the subsequent meeting with management. In other cases, one viewing provided enough reason to pass. (More on that later.)

Due Diligence and Collaboration
No matter how strong a company’s pedigree and prospects, management contact is an integral part of the growth team’s buy and sell decisions.

The team regularly meets with the managers of nearly all of the companies in a portfolio—on average, once a quarter. And prior to purchase, they also may conduct meetings with a company’s suppliers, customers, and competitors in order to develop a more complete analysis of the company’s fundamentals. 

“Only through a meeting with the management can we really judge their competency and credibility,” O’Halloran said. “And this is especially true of IPOs, where the managements are presenting their company to the public market for the first time.”

Lately, the Lord Abbett growth team has collaborated with colleagues from the firm’s fixed-income group in such IPO management meetings. After all, some of Lord Abbett’s fixed-income strategies may invest in IPOs, and the way their research analysts look at companies can benefit the growth team.

“Because fixed income offers a fixed return, that team has to be, and is much better, than we are at downside protection.” O’Halloran explained. “So typically in an IPO meeting, my questions are about exploring the upside, while my fixed-income colleagues are gauging the downside risk. It makes for a better, complementary meeting for each of us.”

Example #1: At a recent meeting with an entrepreneur who was looking to start another airline, fixed-income analysts and portfolio managers grilled him on his debt covenants, capital-spending plans, and the competition, but emerged satisfied. The growth team was impressed with the long-term growth prospects, but passed on buying, because it had enough cyclical growth exposure in its portfolio at the time.

Example #2:  Lord Abbett’s growth and fixed-income teams were both impressed with the IPO presentations of a software company that was poised to become an important player in artificial intelligence and big data. But the night before the IPO, O’Halloran left the office worrying about competition from much larger industry players. As he boarded the parking garage elevator, he ran into Alan Kurtz, the lead portfolio manager for Lord Abbett’s convertible securities strategy, who didn’t seemed worried at all. “I think that IPO has a lot of upside,” he said. O’Halloran appreciated the reassurance.

Looking Ahead
At a recent firm-wide orientation panel, O’Halloran was unequivocal about the secular bull market in technology and the role such companies will play in Lord Abbett’s growth portfolios.

“I think we’re in year 60 of the technology revolution, and that it will last 200 years,” said O’Halloran, who spent years as a venture capital and special situations analyst before becoming a portfolio manager.

Broadly defined, the current, ongoing technology revolution is manifesting itself in software and networking (e.g., cloud computing, artificial intelligence, deep learning, data mining, cybersecurity, the “Internet of Things”); modern medicine (e.g., advances in genomics, immunotherapy, the war on cancer, the war on Alzheimer’s); advanced manufacturing; driverless or semiautonomous automobiles; the latest iterations of e-commerce, and other areas.

The revolution also is evidenced by the ongoing consolidation of wireless, cable, Internet, and content providers, next-generation networking, which could transform the competitive landscape. Fifth-generation (5G) wireless networking, once it is rolled out, has the potential to transform the digital divide between urban and underserved rural areas, and accelerate expansion of the Internet of Things by connecting billions of microchip-enabled products.

Whether the breakthroughs are overcoming the distance, spatial, and time constraints of human existence, or automating what we humans do, the technology revolution is in full bloom. And O’Halloran believes this revolution has a substantial runway ahead.

Never one to underestimate the impact of progress and innovation that Austrian economist Joseph Schumpeter described as “creative destruction,” O’Halloran subscribed to the view that a colossal supercycle of innovation in enterprises is about to unfold.

As John Michaelson, CEO of Michaelson Capital Partners, put it in a recent op-ed piece in The Wall Street Journal, “The combination of advances in [computer] platforms and intolerable pain is about to result in an explosion in entirely new applications that are inexpensive to operate, are far less likely to fail, are far more secure, and easily accommodate unimagined advances in ease of use and effective output. This scenario will be seen in sector after sector.”2

 

1Jackie Kelley, EY Americas IPO Markets Leader, “Global IPO Trends: Q1 2017,” EY, April 2016.
2John Michaelson, “Prepare for a New Supercycle of Innovation,” The Wall Street Journal, May 10, 2017.

 

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

Alpha is a measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund's alpha.

Risks to Consider: Investing in international securities generally poses greater risk than investing in domestic securities, including greater price fluctuations and higher transaction costs. Special risks are inherent to international investing, including those related to currency fluctuations and foreign, political, and economic events. The securities markets of emerging countries tend to be less liquid, especially subject to greater price volatility, have a smaller market capitalization, have less government regulation and may not be subject to as extensive and frequent accounting, financial and other reporting requirements as securities issued in more developed countries. Further, investing in the securities of issuers located in certain emerging countries may present a greater risk of loss resulting from problems in security registration and custody or substantial economic or political disruptions. No investing strategy can overcome all market volatility or guarantee future results.

The preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to ma king an investment decision.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education.  None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity.   If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett Funds. This and other important information is contained in the Fund's summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional, Lord Abbett Distributor LLC at 888-522-2388 or visit us at lordabbett.com. Read the prospectus carefully before you invest.

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